Chapter 12 Segment Reporting and Decentralization Learning Objectives LO1 Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs LO2 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI LO3 Compute residual income and understand the strengths and weaknesses of this method of measuring performance LO4 (Appendix 12A) Determine the range, if any, within which a negotiated transfer price should fall New in this Edition • This chapter has been extensively rewritten • Many new In Business boxes have been added • Additional exercises have been written Chapter Overview A Responsibility Accounting Responsibility accounting is concerned with designing reports that help motivate managers to make decisions and to take actions that are in the best interests of the overall organization The benefits of decentralization In a decentralized organization, decision making is not confined to a few top executives, but rather is spread throughout the organization Responsibility accounting functions most effectively in an organization that is decentralized A number of benefits result from decentralization a Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, higher-level decision-making and coordinating activities b Lower-level managers generally have more detailed and up-to-date information about local conditions than top managers Therefore, lower-level managers are often capable of making better operational decisions c Delegating decision-making authority to lower-level managers enables them to quickly respond to customers 755 d Decentralization provides lower-level managers with the decision-making experience they will need when promoted into higher-level positions e Delegating decision-making authority to lower-level managers often increases their motivation The end result can be increased job satisfaction and employee retention, as well as improved organizational performance Disadvantages of decentralization Particularly in larger organizations, the benefits of decentralization usually outweigh the disadvantages Nevertheless, it is important to be aware of the potential problems with decentralization a Lower-level managers may make decisions without fully understanding the “big picture.” While top-level managers typically have less detailed information about local operations than the lower-level managers, they usually have more information about the company as a whole and should have a better understanding of the company’s strategy b In a truly decentralized organization, there may be a lack of coordination among autonomous managers This problem can be reduced by clearly defining the company’s strategy and communicating it effectively throughout the organization through the use of a well-designed Balanced Scorecard (see Chapter 10) c Lower-level managers may have objectives that are different from the objectives of the entire organization For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company To some degree, this problem can be overcome by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company Investment, Profit, and Cost Centers There are at least three types of responsibility centers a A cost center manager has control over cost Cost center managers are evaluated based on how well costs are controlled, given the level of activity b A profit center manager has control over both cost and revenue Profit center managers are usually evaluated based on performance relative to profit targets c An investment center manager has control over cost and revenue and also has control over the use of investment funds Investment center managers are usually evaluated based on rate of return on investment (ROI) B Segmented Reporting (Exercises 12-1, 12-5, 12-7, and 12-8.) To operate effectively, managers need a great deal more information than is provided by a single, company-wide income statement Income statements are needed that focus on segments of the company Segments A segment is any part or activity of an organization about which a manager seeks cost or revenue data Examples of segments include sales territories, manufacturing facilities, service centers, individual products, and individual customers 756 Segmented statements Segmented statements can be prepared for activity at many different levels in an organization Exhibit 12-2 in the text illustrates three levels of segmented statements Sales and contribution margin Sales for each segment should be identified along with variable costs, resulting in a contribution margin The segment contribution margin is especially valuable in decisions that involve the use of excess capacity Traceable vs Common Fixed Costs Whether a fixed cost is assigned to a segment should depend on whether it is traceable to that segment or is a common cost A cost may be traceable to one segment and common to another a Traceable Fixed Costs Traceable costs arise because of the existence of a particular segment If a cost is avoidable if a segment were discontinued, then it is a traceable cost of that segment b Common Fixed Costs A common fixed cost is a fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments A fixed cost that is common to a particular segment would continue even if that particular segment were discontinued Since common costs are not avoidable costs of the segment, they should not be considered costs of the segment for purposes such as product drop decisions or pricing Of course, it is always possible to arbitrarily allocate any cost—including common fixed costs—among segments However, if common costs are allocated among segments, the resulting segment statements are potentially very misleading and erroneous decisions may result For example, a manager might drop a segment that appears to be operating at a loss, only to discover later that the common fixed costs that were arbitrarily allocated to the segment not disappear and are simply reallocated to the remaining segments c Do common costs exist? There is a great deal of disagreement about what costs are and are not traceable to segments • Some people allege that essentially the only costs traceable to products are direct materials whereas others assert that all costs can be traced to products That is, some commentators believe almost all costs are common with respect to products whereas others believe there are no common costs at all (For example, the early ABC literature implicitly assumed common costs not exist.) Our belief is that the truth lies somewhere in the middle—a lot of costs can be traced to products but by no means all costs The illustrations in the text and in the exercises, problems, and cases reflect that belief • Cooper and Kaplan, the leading architects of activity-based costing, have advocated a system of segmented reports that is very much in the spirit of what we recommend in this chapter They define a hierarchy of costs in which costs can be usefully aggregated upwards but should not be allocated downwards Essentially, costs at each level of the hierarchy are common to the activities carried out lower down in the hierarchy For example, they advocate that facility-sustaining costs, which are common to products, should not be allocated to the products (See Cooper and Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May-June 1991, pp 130-135.) 757 • With so much disagreement among the experts concerning which costs can and cannot be traced to products, it should not be surprising that there is a great deal of uncertainty in practice concerning whether a particular cost is traceable or not The text and problem material have been carefully worded to eliminate this sort of ambiguity The introductory course does not seem to us to be the most appropriate place to grapple with all of the complexities of this issue d What is common and what is traceable depends on the segment A cost that is traceable to a segment may not be traceable when the segment is further divided into smaller segments The salary of the vice president of the automotive products division is a traceable cost of the segment “automotive products division” but it is not a traceable cost of any particular product that is sold by the division This is true even if someone were to keep track of how much time the vice president devotes to each particular product Segment Margin The segment margin is obtained by deducting the traceable fixed costs of a segment from the segment’s contribution margin The segment margin indicates how much the segment is contributing toward covering common costs and towards profits C Return on Investment (ROI) for Measuring Managerial Performance (Exercises 12-2, 12-6, 12-9, 12-10, 12-11, and 12-13.) Investment centers are usually evaluated based on some measure of the rate of return on investment; that is, some measure of profits divided by some measure of investment This presumably provides incentives to increase profits while controlling the amount of funds tied up in an organization The definition of ROI Companies measure the rate of return on investment in many different ways To keep things simple, we use the following definition in the book: ROI = Net operating income Average operating assets Net operating income is income before interest and taxes Average operating assets are discussed below Measuring Average Operating Assets a From a theoretical standpoint, one can argue that the denominator in the ROI formula should be the market value of the segment at the beginning of the period The investment in the segment is implicitly the proceeds that could have been realized from its sale Unfortunately, reliable estimate of the market value of a segment are difficult to obtain So that approach is rarely, if ever, used in practice b In the text we define operating assets as cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization And after some discussion of net book value versus original cost as a basis for valuation, we settle on net book value This way of measuring the denominator in the ROI calculations is pretty typical of practice We suggest you not dwell on this issue in class; the figures for average operating assets are given in all of the exercises and problems 758 ROI in terms of Margin and Turnover A company’s ROI can be expressed as a simple function of its margin and turnover: ROI = Margin × Turnover or Net operating income Sales × ROI = Sales Average operating assets ROI in this format provides some valuable insights Very roughly speaking, in long-run equilibrium the ROI should be about the same across all industries If the ROI is above the norm in any industry, investment dollars will flood into that industry until the ROI becomes comparable to the ROIs in other industries Therefore in industries characterized by large turnovers, margins should be relatively small and in industries characterized by relatively small turnovers, margins should be relatively large The trick for a company is to try to break out of this long-run equilibrium position and to realize some combination of margins and turnover that is higher than the norm How actions affect the rate of return ROI can be improved by doing at least one of the following: increasing sales, reducing expenses, or reducing assets a Ordinarily, an increase in sales will increase margin and turnover because of leverage Since fixed costs not increase with sales, net operating income should increase faster than sales, and the margin should go up And modest increases in sales can often be supported with very little increase in operating assets b A decrease in expenses will increase margins through an increase in net operating income In hard times, managers often turn to cost cutting as the first line of defense Conventional wisdom holds that “fat” can creep into an organization during good times and that such fat can be cut away without a great deal of pain when necessary Critics point out that morale suffers during and after periodic cost cutting binges It is now generally acknowledged that it is best to always be “lean and mean” and to avoid the wrenching effects caused by cost cutting campaigns c Many approaches to increasing ROI involve increasing operating assets or expenses in order to improve sales and margins The problem of allocated expenses and assets In practice, corporate headquarters expenses and other common costs are usually allocated to divisions Arbitrary allocations of common costs should be avoided in ROI computations They undermine the credibility of the measure of performance, generate arguments among managers, and serve no apparent useful purpose Criticisms of ROI The use of ROI as a performance measure has been criticized a ROI tends to emphasize short-run rather than long-term performance Managers can often improve short-term profitability by taking actions that hurt the company in the long-term Prominent examples include neglecting maintenance and training, slashing prices at the end of the fiscal year to induce customers to make unusually large purchases in advance of their needs, purchasing lower quality inputs, and skimping on quality control 759 b A manager who takes over an investment center typically inherits many committed costs over which the manager has little control These committed costs may be relevant for assessing how well the investment center has performed as an investment, but are less relevant for assessing how well the current manager is performing c A division may reject an investment that would lower its own ROI even though it would increase the ROI for the entire company D Residual Income (Exercises 12-3, 12-12, 12-14, and 12-16.) Residual income (or economic value added) is an alternative to ROI for measuring the performance of an investment center Motivation for the residual income approach Profitable investments may be rejected if a segment is evaluated based on the ROI formula For example, suppose a company’s minimum required rate of return on new investments is 15% and one of its investment centers currently has an ROI of 20% If a new investment promises a return of greater than 15%, the company would want that investment made However, if the investment’s rate of return is less than 20%, it would be rejected by the manager of the investment center The residual income approach does not suffer from this particular problem, but it does suffer from many of the other problems with ROI Definition of residual income Residual income is the net operating income that an investment center is able to earn above the minimum required rate of return on its operating assets Ideally, the minimum required rate of return should be the company’s cost of capital or opportunity cost of funds When residual income is used to measure performance, the goal is to maximize the total amount of residual income generated for a period Divisional comparison and residual income A major disadvantage of the residual income approach is that it cannot be easily used to compare the performance of divisions of different sizes Larger divisions naturally have more residual income than smaller divisions, not necessarily because they are better managed, but simply because they are bigger Nevertheless, residual income can be used to track the performance of a division over time and actual residual income can be compared to target residual income Economic Valued Added (EVA) The residual income approach, which was never as popular as ROI in practice, has been given new life and is now being used by a number of prominent companies in the form of “economic value added” or EVA The consulting firm Stern Stewart is largely responsible for this revival and has trademarked the terms economic value added and EVA Many other consulting firms have jumped on the bandwagon and give residual income their own unique twists and marketing nomenclature The major differences between traditional residual income and economic value added in the Stern Stewart approach center on the accounting treatment of some transactions For example, research and development costs are capitalized and then amortized under the EVA approach rather than being currently expensed in their entirety However, we believe it is best not to emphasize these differences between residual income and EVA in the introductory course E (Appendix 12A) Transfer Pricing (Exercises 12-4, 12-15, and 12-17.) A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company Transfer prices are necessary to calculate costs and revenues in cost, 760 profit, and investment centers Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price Do transfer prices matter? From the standpoint of the company as a whole, the transfer price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries) What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process From an economic perspective, it is like taking money out of one pocket and putting it into the other What does matter is how the transfer price affects the decisions made by the segment managers In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division Negotiated transfer prices In principle, if managers understand their own businesses and are cooperative, negotiated transfer prices should work quite well a If a transfer is in the best interests of the entire company, the profits of the entire company should increase It is always possible in such a situation (barring externalities) to find a transfer price that would increase each participating division’s profits A pie analogy is helpful to explain this principle The profits of the entire company are the pie By cooperating in a transfer, the division managers can make the pie bigger With a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece And transfer prices provide a means for dividing up the pie b While negotiated transfer prices can work quite well under the right conditions, if managers are uncooperative and highly competitive, negotiations may go nowhere The lowest acceptable transfer price for the selling division Clearly, the selling division would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer Therefore, the lowest acceptable transfer price as far as the selling division is concerned is: Transfer price ≥ Variable cost + Total contribution margin of lost sales Total number of units transferred When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero Highest transfer price the buying division is willing to pay In the book and in problems, we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier In that case, the buying division clearly would not voluntarily agree to a transfer unless: Transfer price ≤ Cost of buying from outside supplier 761 The range of acceptable negotiated transfer prices Combining the selling and buying divisions’ perspectives, we can find the range within which a negotiated transfer price will lie Two situations should be considered a A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside In algebraic form: Variable + Total contribution margin of lost sales ≤ Cost of purchasing from outside supplier cost Total number of units transferred In this case, any transfer price within the following range will increase the profits of both divisions: Variable + Total contribution margin of lost sales ≤ Transfer ≤ Cost of purchasing from outside supplier cost price Total number of units transferred b A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs) In algebraic form: Variable + Total contribution margin of lost sales ≥ Cost of purchasing from outside supplier cost Total number of units transferred In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company Alternative approaches to transfer pricing If managers understand their own businesses and are cooperative, negotiated transfer prices should work very well But, if managers not understand their own businesses or are uncooperative, negotiations are likely to be fruitless As a consequence, most companies rely on either cost-based or market pricebased transfer prices a Cost-based transfer prices In many companies, transfers are recorded at variable cost, at full cost, or at variable or full cost plus some arbitrary mark-up These transfer pricing systems are easy to administer, but suffer from serious limitations • Cost-based transfer prices can easily lead to bad decisions If variable costs are used, the transfer price will be too low when there is no idle capacity If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company • If there is no profit margin built into the transfer price, then the selling division has no incentive to cooperate in the transfer 762 • If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization If transfer prices are to be based on cost, then standard cost rather than actual cost should be used b Market-based transfer prices When there is a competitive outside market for the good or service transferred between the divisions, the market price is often used as a transfer price This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume 763 Assignment Materials Assignment Exercise 12-1 Exercise 12-2 Exercise 12-3 Exercise 12-4 Exercise 12-5 Exercise 12-6 Exercise 12-7 Exercise 12-8 Exercise 12-9 Exercise 12-10 Exercise 12-11 Exercise 12-12 Exercise 12-13 Exercise 12-14 Exercise 12-15 Exercise 12-16 Exercise 12-17 Problem 12-18 Problem 12-19 Problem 12-20 Problem 12-21 Problem 12-22 Problem 12-23 Problem 12-24 Problem 12-25 Problem 12-26 Problem 12-27 Problem 12-28 Problem 12-29 Problem 12-30 Problem 12-31 Problem 12-32 Case 12-33 Case 12-34 Case 12-35 Level of Topic Difficulty Basic segmented income statement Basic Compute the return on investment (ROI) Basic Residual income Basic (Appendix 12A) Transfer pricing basics Basic Segmented income statement Basic Effects of changes in sales, expenses, and assets on ROI Basic Working with a segmented income statement Basic Working with a segmented income statement Basic Effects of changes in profits and assets on return on investment (ROI) Basic Cost-volume-profit analysis and return on investment (ROI) Basic Return on investment (ROI) Basic Evaluating new investments using return on investment (ROI) and residual income Basic Computing and interpreting return on investment (ROI) Basic Contrasting return on investment (ROI) and residual income Basic (Appendix 12A) Transfer pricing from the viewpoint of the entire company Basic Return on investment (ROI) and residual income relations Basic (Appendix 12A) Transfer pricing situations Basic Segment reporting and decision-making Basic Comparison of performance using return on investment (ROI) Basic Return on investment (ROI) and residual income Basic (Appendix 12A) Transfer price with an outside market Basic Basic segmented reporting; activity-based cost assignment Basic Return on investment (ROI) and residual income Basic (Appendix 12A) Basic transfer pricing Basic Restructuring a segmented income statement Basic Segment reporting; activity-based cost assignment Medium Return on investment (ROI) analysis Medium Return on investment (ROI) and residual income; decentralization Medium (Appendix 12A) Market-based transfer price Medium Multiple segmented income statements Medium (Appendix 12A) Cost-volume-profit analysis; return on investment (ROI); transfer pricing Medium (Appendix 12A) Negotiated transfer price Medium Segmented statements; product line analysis Difficult (Appendix 12A) Transfer pricing; divisional performance Difficult Service organization; segment reporting Difficult 764 Suggested Time 15 10 10 30 20 20 20 15 30 20 15 30 15 20 15 15 20 30 30 30 45 60 20 60 60 60 30 30 45 60 45 30 90 45 75 TM 12-6 Graphic Presentation of Segment Reporting (Exhibit 12-2) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-7 DANGERS IN ALLOCATING COMMON COSTS Common costs should not be allocated among segments If common costs are allocated, then the results can be misleading to management EXAMPLE: Suppose the common costs of Mary’s Market were allocated on the basis of sales (a frequently used allocation basis) Sales Less variable costs Contribution margin Less traceable fixed costs Divisional segment margin Less allocated common fixed costs Net operating income Total Company $1,500,000 810,000 690,000 400,000 290,000 240,000 $ 50,000 Product Lines Meats Produce $900,000 $600,000 460,000 350,000 440,000 250,000 230,000 170,000 210,000 80,000 144,000 96,000 $ 66,000 $(16,000) If the Produce Department were closed down because of its apparent loss, the following would be expected to occur: Sales Less variable costs Contribution margin Less traceable fixed costs Divisional segment margin Less allocated common fixed costs Net operating income Total Company $900,000 460,000 440,000 230,000 210,000 240,000 $(30,000) Product Lines Meats Produce $900,000 460,000 440,000 230,000 210,000 240,000 $(30,000) © The McGraw-Hill Companies, Inc., 2006 All rights reserved — — — — — — — TM 12-8 RETURN ON INVESTMENT Investment centers are often evaluated based on their return on investment (ROI), which is computed as follows: ROI = Net operating income Average operating assets or ROI = Margin × Turnover where: Margin = Turnover = Net operating income Sales Sales Average operating assets EXAMPLE: Regal Company reports the following data for last year’s operations: Net operating income Sales Average operating assets ROI = $30,000 $500,000 $200,000 $30,000 $500,000 × = 6% × 2.5 = 15% $500,000 $200,000 To increase ROI, at least one of the following must occur: Increase sales Reduce expenses Reduce operating assets © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-9 RETURN ON INVESTMENT (cont’d) Example 1—Increase sales: Assume that Regal Company is able to increase sales to $600,000 Net operating income increases to $42,000, and the operating assets remain unchanged ROI = $42,000 $600,000 × = 7% × 3.0 = 21% $600,000 $200,000 (compared to 15% before) Example 2—Reduce expenses: Assume that Regal Company is able to reduce expenses by $10,000 per year, so that net operating income increases from $30,000 to $40,000 Sales and operating assets remain unchanged ROI = $40,000 $500,000 × = 8% × 2.5 = 20% $500,000 $200,000 (compared to 15% before) Example 3—Reduce assets: Assume that Regal Company is able to reduce its average operating assets from $200,000 to $125,000 Sales and net operating income remain unchanged ROI = $30,000 $500,000 × = 6% × 4.0 = 24% $500,000 $125,000 (compared to 15% before) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-10 RESIDUAL INCOME Residual income is the net operating income that an investment center earns above the minimum rate of return on its operating assets EXAMPLE: Marsh Company has two divisions, A and B Division A has $1,000,000 and Division B has $3,000,000 in average operating assets Each division is required to earn a minimum return of 12% on its investment in operating assets Division A Division B Average operating assets $1,000,000 $3,000,000 Net operating income Minimum required return: 12% × average operating assets Residual income $ 200,000 $ 450,000 120,000 $ 80,000 360,000 $ 90,000 Economic value added (EVA) is a concept similar to residual income EVA has been adopted by many companies in recent years © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-11 RESIDUAL INCOME (cont’d) The residual income approach encourages managers to make profitable investments that would be rejected under the ROI approach EXAMPLE: Marsh Company’s Division A has an opportunity to make an investment of $250,000 that would generate a return of 16% on invested assets (i.e., $40,000 per year) This investment would be in the best interests of the company since the rate of return of 16% exceeds the minimum required rate of return However, this investment would reduce the division’s ROI: Present Average operating assets (a) $1,000,000 Net operating income (b) $200,000 ROI (b) ÷ (a) 20.0% New Project Overall $250,000 $1,250,000 $40,000 $240,000 16.0% 19.2% On the other hand, this investment would increase the division’s residual income: Average operating assets (a) $1,000,000 $250,000 $1,250,000 Net operating income (b) Minimum required return: 12% × (a) Residual income $ 200,000 $ 40,000 $ 240,000 120,000 $ 80,000 30,000 $ 10,000 150,000 $ 90,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-12 TRANSFER PRICING A transfer price is the price charged when one segment (for example, a division) provides goods or services to another segment of the same company • Transfer prices are necessary to calculate costs in a cost, profit, or investment center • The buying division will naturally want a low transfer price and the selling division will want a high transfer price • From the standpoint of the company as a whole, transfer prices involve taking money out of one pocket and putting it into the other • An optimal transfer price is one that leads division managers to make decisions that are in the best interests of the company as a whole Three general approaches are used in practice to set transfer prices: Negotiated price Cost-based price a Variable cost b Full (absorption) cost Market price © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-13 NEGOTIATED TRANSFER PRICES When division managers work well together and understand their businesses, a negotiated transfer price is an excellent solution to the transfer pricing problem If a transfer is in the best interests of the entire company, division managers bargaining in good faith should be able to find a transfer price that increases the profits of both the divisions The lowest acceptable price from the viewpoint of the selling division: Total contribution margin on lost sales Transfer ≥ Variable + price cost Number of units transferred The highest acceptable price from the viewpoint of the buying division when the unit can be purchased from an outside supplier: Transfer ≤ Cost of buying from outside supplier price © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-14 TRANSFER PRICING EXAMPLES EXAMPLE: The Battery Division of Barker Company makes a standard 12volt battery Production capacity (number of batteries) Selling price per battery to outsiders Variable costs per battery Fixed costs per battery (based on capacity) 300,000 $40 $18 $7 Barker Company has a Vehicle Division that could use this battery in its forklift trucks The Vehicle Division would like to buy 50,000 batteries per year It is presently buying these batteries from an outside supplier for $39 per battery Battery Division Selling price: $40 Transfer Price: ? Outside Market for Vehicle Batteries Purchase price: $39 Vehicle Division Forklift Trucks © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-15 TRANSFER PRICING EXAMPLES (cont’d) Situation 1: Suppose the Battery Division is operating at capacity What is the lowest acceptable transfer price from the viewpoint of the selling division? Total contribution margin on lost sales Transfer ≥ Variable + price cost Number of units transferred Transfer ≥ $18 + ($40-$18)×50,000 = $18 + ($40 - $18) = $40 price 50,000 But, the buying division will not pay more than $39, the cost from buying the batteries from the outside So the two managers will not be able to agree to a transfer price and no transfer will voluntarily take place Transfer ≤ Cost of buying from outside supplier = $39 price From the standpoint of the entire company, no transfer should take place since the company gives up $40 in revenues, but saves only $39 in costs © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-16 TRANSFER PRICING EXAMPLES (cont’d) Situation 2: Assume again that the Battery Division is operating at capacity, but suppose that the division can avoid $4 in variable costs, such as selling commissions, on transfers within the company What is the lowest acceptable transfer price from the viewpoint of the selling division? Total contribution margin on lost sales Transfer ≥ Variable + price cost Number of units transferred Transfer ≥ $18 - $4 + ($40 - $18) × 50,000 = $36 ( ) price 50,000 Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside Transfer ≤ Cost of buying from outside supplier = $39 price In this case an agreement is possible Any transfer price within the range $36 ≤ Transfer price ≤ $39 will increase the profits of both of the divisions From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $36 and the company saves $39, for a net gain of $3 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-17 TRANSFER PRICING EXAMPLES (cont’d) Situation 3: Refer to the original data Assume that the Battery Division has enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market, but there is no savings in variable costs on the transfer inside the company What is the lowest acceptable transfer price from the viewpoint of the selling division? In this case there are no lost sales Total contribution margin on lost sales Transfer ≥ Variable + price cost Number of units transferred Transfer ≥ $18 + $0 = $18 price 50,000 Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside Transfer ≤ Cost of buying from outside supplier = $39 price And again in this case an agreement is possible Any transfer price within the range $18 ≤ Transfer price ≤ $39 will increase the profits of both of the divisions From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $18 and the company saves $39, for a net gain of $11 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-18 TRANSFER PRICING EXAMPLES (cont’d) Situation 4: The Vehicle Division wants the Battery Division to supply it with 20,000 special heavy-duty batteries • The variable cost for each heavy-duty battery would be $27 • The Battery Division has no idle capacity • Heavy-duty batteries require more processing time than regular batteries; they would displace 22,000 regular batteries from the production line What is the lowest acceptable transfer price from the viewpoint of the selling division? Total contribution margin on lost sales Transfer ≥ Variable + price cost Number of units transferred Transfer ≥ $27 + ($40 - $18) × 22,000 = $27.00 + $24.20 = $51.20 price 20,000 In this case, the opportunity cost of producing one of the special batteries is $24.20, the average amount of lost contribution margin © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-19 TRANSFER PRICING EXERCISE Division A capacity Division A outside sales Division B needs Division A: Normal variable cost Variable costs avoided on internal sales Fixed cost per unit based on capacity Outside selling price Division B: Purchase price from outside supplier Range of acceptable transfer prices Case Case Case Case 100,000 100,000 30,000 500,000 500,000 80,000 250,000 200,000 50,000 400,000 300,000 100,000 $40 $ 60 $30 $50 $0 $10 $0 $2 $10 $70 $25 $100 $8 $45 $12 $80 $68 $96 $43 $75 ? ? ? ? Answers: Case 1: No Transfer will take place Case 2, $90 ≤ Transfer price ≤ $96 Case 3, $30 ≤ Transfer price ≤ $43 Case 4, $48 ≤ Transfer price ≤ $75 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 12-20 COST-BASED TRANSFER PRICES Transfer prices based on cost are easily understood and convenient to use and not require negotiation Unfortunately, cost-based transfer prices have several disadvantages: • Cost-based transfer prices can lead to bad decisions (For example, they don’t include opportunity costs from lost sales.) • The only division that will show any profit on the transaction is the one that makes the final sale to an outside party • Cost-based transfer prices provide no incentive for control of costs unless transfers are made at standard cost MARKET-BASED TRANSFER PRICES When item being transferred has an active outside market, the market price may be a suitable transfer price However, when the selling division has idle capacity, the market price will overstate the real cost to the company of the transfer and may lead the buying division manager to make bad decisions © The McGraw-Hill Companies, Inc., 2006 All rights reserved [...]... Problem 12-31, Problem 12-32, Case 12-34 765 1 2 766 Chapter 12 Lecture Notes Helpful Hint: Before beginning the lecture, show students the 14th and 15th segments from the McGrawHill/Irwin Managerial/ Cost Accounting video library These segments discuss many of the concepts included in chapter 12 The lecture notes reinforce the concepts in the video 1 I Chapter theme: Managers in large organizations have... notes reinforce the concepts in the video 1 I Chapter theme: Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (ROI) and residual income measures are used to help control decentralized organizations Decentralization in organizations... a This problem can be reduced through the effective use of intranet systems, which enable globally dispersed 769 3 4 6 770 5 employees to electronically share ideas 3 II 4 Responsibility accounting A Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions The term responsibility center is used for any part of an organization... has control over costs, but not over revenue or investment funds a Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centers, as are manufacturing facilities b Standard cost variances and flexible budget variances, such as those discussed in Chapters 10 and 11, are often used to evaluate cost center performance 5 ii 6 Cost center Profit... residual income, as discussed later in this chapter “In Business Insights” It is important to correctly manage the incentives offered to responsibility center managers, otherwise the consequences can be disastrous For example: “Extreme Incentives” (page 542) • In 2003 Tyco International, Ltd was rocked by a series of scandals including disclosure of $2 billion of accounting- related problems Was this foreseeable?... the lower levels They strongly recommend that these common costs should not be allocated downwards in the pyramid This conceptualization is highly consistent with the segmented reports discussed in this chapter B Segmented income statements – an example i 21 22 23 24 25 Assume that Webber, Inc has two divisions – the Computer Division and the Television Division 1 The contribution format income statement